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8/25/2010

A brief history of 401K

This is a first post in 25 part series on 401K I will be writing for next few weeks on the Members site. After I finish all articles I will compile then as a separate section under trading guide. The series will go in to details of designing your own approach to 401K investment after understanding available choice of strategies. It will go in to details of tools and formats used for tracking the 401K.

A 401K is a tax deferred, defined contribution retirement plan. The name comes from a section of the Internal Revenue Code that permits an employer to create a retirement plan to which employees may contribute a portion of their wages on a pretax basis. This section allows the employer to match employee contributions with tax-deductible company contributions. Earnings on all contributions are allowed to accumulate in a tax-deferred trust.

If you read books on 401K or internet sites on 401K, most will tell you that Congress enacted 401K law when it modified ERISA in 1978. That is not true. It is completely wrong information and it gets circulated again and again.

401K was not the idea of some smart legislator. The 401K name comes from a section of the IRS code. This section was added in 1978 but for 2 years no one paid much attention to it. A creative interpretation of that provision by a smart lawyer gave birth to first 401k plan. The govt tried to repeal the 401K provision twice once it realized the enormous tax loss from the 401K provision.

401K plans as they evolved today are a brainchild of Ted Benna, a retirement benefit consultant working for a Pennsylvania based Johnson Cos. (not Johnson and Johnson as most sites wrongly claim). He devised the plan for a client who declined to use it because of the fear that once Govt realized the tax loss potential of the plan the 401k provision will be repealed. After the client rejected it, Ted Benna persuaded his own company to use it.

That started the first 401K plan in 1981. 401K plan will be 30 year old next year and currently estimated to have around 3 Trillion invested in them. The 401K have revolutionized the retirement planning approach. Now most employees offer a 401K plan.

Here is a brief encapsulation of the history of the birth of 401K as told by Ted Benna:

Yes I do remember it well. It was a quiet Saturday afternoon when I was in my office without the distraction of a ringing telephone and co-workers wandering into my office. You should know there is myth and reality about what I actually did.

First the myth. I supposedly was sitting in my office reading the Internal Revenue Code when I discovered this little gem that no one else had found. Frankly I don't know how the myth started but it isn't true. Many people, including me, were aware the portion of the IRS Code that I used to design the first 401(k) savings plan existed. Because this provision was added to the Code for an entirely different purpose, no one had considered using it in the manner that I was about to propose.

I was in fact redesigning the retirement program for one our bank clients. At the time, I was a consultant and co-owner of The Johnson Companies -- a small benefits consulting firm located in suburban Philadelphia. As I was considering the bank's goals, I was drawn back to Section 401(k) of the Code. The bank wanted to replace its cash bonus plan with a deferred profit sharing plan where employees wouldn't have access to the money until they left the bank. The president wanted to add this type of plan because the president wanted the tax break and the bank needed the plan to be competitive with other area banks.

Several years earlier, I had designed a plan for another bank to do the same thing. At that time, the only option available was to replace the entire cash bonus with a contribution to a plan to give employees additional retirement benefits. Most of the employees weren't thrilled to have the cash bonus replaced by a plan that tied up their money for retirement.

I didn't want to have this happen again so I pondered how to satisfy the president without getting most of the other employees ticked off. It was in fact a bit of desperation that got the creative juices flowing. I realized Section 401(k) that had become effective as of January 1, 1980 provided some hope. I could use this section to design a plan allowing each employee to put into the plan whatever portion of the cash bonus he or she wanted. The only catch was that I had to get the lower-paid two thirds to put enough money into the plan to allow the top one third to contribute as much as they wanted.

Employees who put money into the plan would get a tax break but I knew this wouldn't be enough to get many of the lower-paid employees to put money into the plan. This is when I thought of adding a matching employer contribution as an additional incentive. I was reasonably confident I could get favorable results through the combined incentive of a tax break plus an employer matching contribution.

It was at this point when the potential of what I had just "created" hit. Most large employers had savings plans at the time where employees put money in after-tax and received a matching employer contribution. The Johnson Companies has such a plan. I immediately realized it would be possible to change all these plans so that employees would be able to put their money in pre-tax rather than after-tax.

The bank actually rejected the idea because their attorney didn't want them doing something that had never been done before. As a result, the first plan we did was for our employees at The Johnson Companies. This is what started the 401(k) savings plan evolution.

The advent of 401K plan brought about a fundamental shift in employers approach to retirement planning. Pre 401K era employers would offer guaranteed retirement plans. After 401K plans became popular the employee is in charge of his own pension plan. The employer just offer a opportunity for employees to create their own retirement plan. The employer is just a plan sponsor and the employees are plan participants.

In next post we will look at key features of 401k plan and why you need to understand and appreciate them.

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